Bank stress tests or how governments are trying to fool the market

European governments are under pressure to shore up the banking sector in the face of growing worries about the industry’s capital levels, access to funding and earning power in the context of global crisis. Indeed, weakened by their bad sovereign debt holdings, several banks are scrutinized by the credit rating agencies and two of them, the French Société Générale and Crédit Agricole have recently been downgraded by Moody’s.

Only two months ago, last July, the European Banking Authority (EBA) didn’t see the problem coming when it released its annual stress test ratings. This is however not surprising, since the risk of sovereign default was not integrated in the model used by the EBA.

The EU-wide stress-test was launched by EBA in cooperation with the European Systemic Risk Board (ESRB), the European Central Bank (ECB) and the EU Commission in 2009, in the aftermath of the subprime crisis. Its official ambition is to « assess the resilience of financial institutions to adverse market developments, as well as to contribute to the overall assessment of systemic risk in the EU financial system ». Unofficially, the test was established with the precise aim to reassure financial markets and, to some extent, to offset the evaluation made by the major credit rating agencies.

This is one of the explanations of the fact that the stress test realized by official and reputed EU experts reveals to be short-sighted and actually outdated only two months after its release. Their aim was not to assess the real situation with European banks but to send a strong signal to market players and bank’s clients, reassuring them in the reliability of those that are holding their money (the second explanation being the unfitness of macroeconomic models themselves when it comes to make reliable predictions). Unhappy with the “severity” of credit rating agencies regarding sovereign debt ratings, the bureaucrats decided to take control and provide themselves the assessment of the health of financial markets and banking sector. This is as credible as the grade a student will give to himself if he was asked to evaluate his or her work. But it didn’t do the job: the markets were more vigilant than expected.

The correct assessment, once again, came from the private credit rating agencies, that did not “forget” to include the risk of sovereign default into their models. But government officials are far from having learned their lesson (do they want to learn?). Instead of concentrating their efforts on solving deficits and public debt problems, they rather discredit the credit rating agencies, bemoaning their influence on financial markets. Next, in a desperate try to extend government control and force the market to behave “the right way”, politicians do not hesitate to push for radical solutions such as banks’ nationalizations and financial transactions taxes. Surely not the proper strategy to calm down financial markets and to stimulate investment and economic growth.